In Ted Butler's Archive

Real Regulatory Reform

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

There is a lot to cover, so I apologize in advance for the length of this piece. While I have been thinking about Commodity Index Funds a lot lately, and discussing them with close associates for months, I hadn’t really planned on writing about them at this time. But events have dictated otherwise, particularly the attention given to the impact of index funds on commodity prices. Just this weekend Barrons carried an important cover story. The article basically highlighted just how large the size of the index funds’ positions had grown and what the price impact was likely to be (very negative) if these positions were sold. Regular readers may remember I have written about the role of the index funds in the past.

First, some recent updates on silver. The most recent Commitment of Traders Report (COT) indicated expected significant selling by the tech funds (not to be confused with the index funds) and buying by the commercials in both gold and silver, although not to the extent I had predicted. The total commercial net short position in silver was reduced by 12,000 contracts, or 60 million ounces, versus an expectation by me of 20,000 contracts. In COMEX gold, the dealers reduced their net short position by 33,000 contracts (3.3 million ounces) against my guess of 75,000 contracts. While my guesses were wide of the mark, the reduction in the respective commercial short positions in silver and gold was still the largest in months.

Even after the sell-off and the reduction in the total dealer net short position, the concentrated short position held by the largest 4 traders is still obscenely large, at almost 290 million ounces. That’s because the raptors (the commercial traders other than the 8 largest traders) in both gold and silver, bought aggressively on the decline, with the raptors buying 7000 of the net 12,000 commercial silver contracts bought, and 17,000 of the 33,000 net gold contracts. The raptors are now more net long in silver than at any time in 2008, with the gold raptors the most net long since September.

The important point is that the sharp decline in prices during the reporting week ($100 in gold and $2.50 in silver) enabled the commercials to significantly reduce their total net short position. To this day, I know that many observers still believe that the significant reductions in the commercial net short positions in gold and silver (and all other commodities) that always occurs on big price breaks is somehow coincidental, and not causal. I guess no amount of logic and observation can change their minds. It is not possible that it could always be coincidental, especially when it is expected to occur. The commercials rig these price declines expressly to buy as many contracts on the decline by collusively withholding their bids until after prices have declined sharply. It is what they do by nature. This is the very essence of why analysts study the COTs.

What makes this most recent rigged sell-off in silver particularly offensive is that it has occurred smack dab in the middle of the first documented shortage of retail investment silver in history. This unprecedented retail tightness has been accompanied by the first sell-out, due to overwhelming investment demand, of Silver Eagles by the US Mint. This is a first in the 22-year history of the American Eagle bullion coin program, as three and five month sales were the highest ever. This, in spite of sales being constrained by rolling sell-outs. In turn, it has been reported that the Royal Mint of Canada has run out of Silver Maple Leaf coins, due to unexpected demand.

Record demand, no increase in supply and sharp price sell-offs? Your head should be spinning. That cannot occur in a free market. It can only occur in a rigged or manipulated market. That this is clearly a case of the COMEX futures markets dictating and setting the price to the cash market is as blatant a violation of basic commodity law as is possible.

That the regulators at the CFTC and the CME-NYMEX allow it to continue is the greatest regulatory failure in financial history, exceeding even the mortgage debacle, because commodity law is so clear and so few regulators oversee its enforcement. There seems to be a clear divergence between the paper and physical silver markets. This is something so basic that there is no excuse for the regulators not to see it or move against the manipulators, especially when it is explained repeatedly to them.

If the real physical investment demand by small investors, that has dramatically tightened availability of retail forms of silver, spills over into investment demand of 1000 oz bars by industrial consumers and large investors, it will no longer matter that the manipulation has been ignored by the regulators. It will, quite literally, blow the lid off the silver market. Large users and investors may do well to pay heed to the small silver investors, who have handled the market beautifully over the years. The little guys have bought cheap and held for the long term. In silver, their record is second to no one.

The regulators should pay special attention to the worsening retail silver shortage. If it develops into a wholesale shortage, which it can in a New York minute, then the bullion banks charade is over. The regulators should ask themselves what kind of panic could occur if the industrial silver users react to the artificial low prices amid a retail investment shortage, by laying in additional inventory at the first signs of a wholesale shortage. If they think that an industrial user panic, to get a material to keep manufacturing lines open will not be a thousand times more forceful than investment buying, they will learn otherwise in a hurry. The difference between a user panic and an investment surge is that the industrial user is not so much concerned with price as he is with getting sufficient quantities at almost any price.

The regulators should also ask themselves if they still want to protect and coddle the big concentrated silver shorts, at the expense of the investing public and market integrity itself? Are the regulators really sure that the shorts can come up with the real goods in light of current developments? Are they sure just how much real silver the shorts have to put out the shortage fire? Long-term careers and lifetime reputations lie in the balance.

Lately, there has been renewed discussion and debate concerning whether real silver backs the unallocated storage programs in the Perth Mint, Kitco, and others, including Everbank. I think this is an important topic and it is why I have written about it so often in the past. I don’t think it is productive to allow the debate to degenerate into name-calling and a “they have the silver, no they don’t” type exercise. So allow me to offer a simple and constructive solution intended to resolve the issue to everyone/s benefit, most importantly the investors who hold such stored silver programs.

Since the silver backing all these storage programs is undoubtedly held in 1000 oz bars, the industry standard, these programs should simply publish the list of serial numbers, hallmarks, and weights of each bar, along with a statement certifying that these bars correspond with the total investment amounts entrusted to each firm or bank. In other words, the entire public investment in the stored silver along with the total bar identification. This will put the matter to rest in a simple and fair manner.

Serial numbers are the key. This is what I publicly proposed to Barclays Global Investors for their silver ETF. They accommodated their investors and the issue was resolved. This is also what led to the class-action settlement with Morgan Stanley. They couldn’t provide the serial numbers and agreed to settle the suit. This is also the solution to the unallocated silver debate. The Perth Mint, Kitco, and Everbank and others should list the serial numbers. If they do, investors will be reassured about their holdings. If they refuse, investors should be guided accordingly.

And for heaven’s sake, if an investor does decide to quit a an unallocated storage program, don’t take the chance of great delay by ordering out the real silver, or by switching to an allocated program at the same company. Have them send you your money and invest it in real silver elsewhere.

To those who say that the mere publishing of serial numbers (along with hallmarks and specific bar weights) still doesn’t guarantee the real silver is there, I would suggest otherwise. For anyone to publicly lie and misrepresent something so specific as fabricated serial numbers is such a simple case of fraud that I doubt a jury trial would even be necessary to convict on criminal fraud charges.

Silver is still a flat-out buy. Maybe there is more tech fund liquidation possible, as the concentrated shorts struggle to buy back more of their shorts by rigging prices lower. But there is a limit as to how many contracts the shorts can cause to be sold on the downside and I still believe we are close to that limit. I know it sounds counter-intuitive, but it is time to be less cautious as new price lows are recorded. The time to be cautious is when new price highs are achieved. Risk diminishes the lower we go in price. In order to sell high, you must first buy low..

Now, on to the index fund discussion. As I have previously written, index funds operate very differently from the tech funds. The tech funds buy and sell on price signals, mostly various moving averages. They buy on the way up and sell on the way down. This makes the tech funds a perfect food supply for the commercials, who know how to maneuver the tech funds in and out of the markets. The index funds, in contrast, do not trade on price signals but are long term buy and holders who trade infrequently, mostly to roll over their futures positions from one contract month to another as delivery draws near. In addition, the tech funds are different from the index funds in that the tech funds operate on a leveraged or margin basis, whereas the index funds generally have the full cash value of the contracts they own to back all their holdings.

While the tech funds exist to earn short-term speculative returns, the index funds are attempting to generate long-term returns by replicating the performance of various well-known commodity indices. Because the investors behind the index funds are big, blue chip institutional investors, like pension funds, the amount of money collectively involved has grown to a staggering sum, on the order of $200 billion.

This vast sum of money has resulted in the index funds holding truly massive amounts of contracts in many commodities, almost exclusively on the buy, or long side. Because the number of futures contracts and the percentage of the market they represent in many commodities, many have come to question the impact these index funds are having on the price of commodities, most of which have recorded record price highs in recent times.

Have the index funds, due to their sheer size, unduly influenced commodity prices? What downward pressure could be expected if the index funds exited these markets by selling their massive long positions? This was the gist of the Barron’s article. Further, the article suggested the regulators forced the index funds to sell because they exerted too much upward pressure on price, negatively impacting inflation rates for everyone.

Most importantly, how much, if at all, would such an unwinding of index fund futures positions impact the price of commodities, especially silver (and gold)? Up until now, I have tried to frame the issue as objectively as possible. What follows is my opinion concerning silver. For the record, I have little, if any, interest in whether agricultural commodity prices (where most of the index fund debate is centered) go up or down. I am, however, concerned about the regulatory issues involved, although probably not in ways you might guess.

When the index funds got involved in the commodity futures markets several years ago, they were welcomed with open arms by the exchanges. The exchanges, mostly represented by commercial short sellers, thought they had been presented with a source of big money that they could milk. After all, the index funds were prohibited from taking actual delivery by the funds own business plan. When contracts the index funds held came due for delivery, the funds would automatically and religiously roll the contracts over to more deferred contracts.

This set up was manna from heaven for the exchange insider commercial shorts, who never had to worry about a short delivery squeeze from the index funds. The shorts, as the market makers, could dictate how much the index funds had to pay up to roll their contracts over, many times per year. It was the closest thing to a money machine for the shorts as could possibly be imagined – big long positions that couldn’t demand delivery, but had to be rolled over at whatever spread differences the shorts would demand. And the shorts royally raked it in for years.

So what’s the problem? And why are there calls to force the index funds to be forced to sell? The problem is that the shorts, through pure greed, created a Frankenstein. As the index funds’ long positions grew larger, that necessarily required equally large short positions, as there must be a short for every long, and vice-versa. The shorts were happy to accommodate the index funds by shorting more contracts, until conditions in the real market demanded higher prices. Crop failures around the world and demand from China and elsewhere resulted in shrinking inventories and critically tight supply/demand circumstances.

To those who are looking to blame commodity price escalation squarely on the index funds’ doorstep, please think again. Very recently, for example, it has become obvious just how serious a tight supply/demand situation has become in rice, with shortages and export bans being announced. In fact, there is genuine concern of food riots and civil unrest in many urban areas of the developing world, as rice constitutes an important staple in billions of people’s diets. Rice prices have doubled over the past year, for many of the same reasons that have caused other grains and commodities to increase in price. But there is virtually no participation by the index funds in rice futures, so it’s silly to suggest that the funds are responsible for all price increase evils.

With such real supply/demand realities, prices naturally moved higher and the shorts realized, only then, that they had an enormous risk exposure. It wasn’t that the index funds bought more as prices rose, they basically just held the large positions they always held. But because their positions were so large to begin with, it put the shorts in a very bad situation. And since the index funds don’t sell, but buy and hold, the shorts couldn’t buy back their short positions.

Even if prices come down sharply, like they have recently, the index funds still hold. With the full cash value of each contract backing the index funds holdings, they can’t be forced out by margin calls. The tech funds do sell, allowing the commercials to buy back short positions, but not so with the index funds. The commercial shorts can’t buy back the bulk of their short positions unless they can force the index funds to sell. Hence, they are pressuring the CFTC to change the rules and force the index funds to sell.

As I wrote, I don’t have a dog in this fight, but it does gall me to see the commercial shorts angling to change the rules again because they miscalculated. I do think it was a mistake that the regulators didn’t anticipate this problem, but what’s new? In the CFTC’s case, none of the current Commissioners were in office when the index funds first entered the markets, so they bear no personal blame. For continuing to allow the silver manipulation to exist, they deserve plenty of blame. For the index fund problem, I don’t think so.


While I don’t quite comprehend why pension funds and other big institutional investors should have a massive presence in commodity futures contracts in the first place, they appeared to have followed all the rules and it’s inherently unfair to force them out of positions they were legally allowed and encouraged to enter, just because they put the commercial shorts in an uncomfortable position.

One thing I do like about the index funds’ participation is that it finally challenged the decades-long strangle hold the big commercial shorts had on all the markets, that resulted in ultra-low prices. In a very real sense, the index funds were the farmers and commodity producers best friend. Those farmers and producers will surely suffer if the index funds are forced to sell. Perhaps the CFTC will strike a King Solomon-type decision by putting a moratorium on new index fund buying, but not force them to dump existing positions. In any event, it’s not my problem, except for a point I will make shortly..

What does this mean for silver? Not much. Maybe there might be some short-term psychological influence if the index funds are forced to dump unrelated agricultural futures contracts and that results in a general commodity sell-off. But the key point is that there no index fund position in COMEX silver (or gold) futures, thereby making it impossible for there to be index fund forced selling of futures contracts. This can be verified by the small commercial gross long position in any COT report, especially when adjusted for commercial spread positions, which while unreported, certainly exist. (Index fund long positions are recorded in the commercial long category by the CFTC).

Further, silver and gold are, effectively, the only commodities in the index funds’ portfolios that have actively traded physically backed ETFs. Since the index funds don’t deal in margin anyway, they would much prefer to deal in stock-like ETFs than in futures. If they could, the index funds would buy physically backed ETFs on wheat or corn or cotton or crude oil, if such ETFs existed. But they don’t, except for silver and gold. It is my understanding that the index funds make up a high percentage of the total silver and gold ETF holdings.

So even if there ever were forced index fund futures contract liquidation (not a prediction), since there are no futures contract holdings by the index funds in silver or gold, there can’t be futures contract silver and gold liquidation. And there is not the slightest suggestion that there would be any forced liquidation in the gold or silver ETFs, which are under the jurisdiction of the SEC, and quite apart from the current discussion on index fund futures contract positions. The silver ETF, if you remember, was approved by the SEC prior to its inception.

There is one final point I would like to make concerning the problem of the index funds in many commodities that share a commonality with silver. At the heart of the shared problem is a very important basic concept of commodity law. That is the issue of legitimate speculative position limits. Long-time readers may remember that the issue of legitimate speculative position limits is an issue I had raised numerous times in the past with the CFTC. But it has been years since I last raised the issue.

Speculative position limits are, or at least used to be, an important factor in commodity trading regulation. As the term implies, there were limits as to the number of contracts any individual speculative trader or entity could hold in any market, long or short. The reason was to insure that speculators didn’t artificially influence futures prices.

Commodity law is clear that futures prices should not set the price of the real underlying commodity, but should follow, or “discover” the price of the cash market. Setting a strict limit on speculators as to how many futures contracts they could control was a time-honored and effective method of insuring that futures stuck to price discovery and not price-setting. If futures markets grew much larger than the underlying cash market, then the derivatives “tail” would be wagging the real market “dog.” (This is precisely what has occurred in silver.)

Even legitimate hedgers were bound by the same position limits imposed on speculators, unless they could demonstrate a bona fide commercial need to hold a position larger in a specific commodity than what the rigid speculative position limits mandated. Even in the case where a specific exemption from a speculative position limit was granted to a legitimate hedger, the hedger was further restricted to no more than actual inventory owned or no more than 12 months actual production or consumption. (The concept of a producer, say a gold mining company, selling years of production forward via the futures market would never have been allowed).

As time evolved, due to concerns with market liquidity and in order to accommodate ever larger (and profitable) clients, speculative position limits basically fell by the wayside, either by blanket edict raising them or by the granting of endless exceptions to the limits. Legitimate speculative position limits ceased to exist

According to many, the problem with the index funds is centered on their positions being too large and in violation of the concept of legitimate position limits. There is truth in this observation, even though the index funds were granted exemptions (by dealing through swap dealers). The positions held by the index funds do appear to be too large. But it would not be fair to stop there.

If the index funds’ position are too large under the concept of legitimate speculative position limits, they are certainly not alone. The very shorts who are petitioning the CFTC to reduce the positions of the index funds are just as guilty, in many cases, of also violating the concept of legitimate speculative position limits. To impose restrictions solely on the index funds and to let the shorts ignore the same concept would be a travesty. What’s good for the goose, should be good for the gander.

In silver, the abuse of the concept of speculative position limits is particularly egregious, for a number of reasons. For one, the limits are set so high as to not limit anyone. They don’t even call them speculative position limits, instead they are called accountability limits (whatever that means). That limit is 7500 contracts, or 37.5 million ounces. That’s roughly equal to the entire annual silver production of the US or Canada. But to add insult to injury, any trader can exceed even the accountability limit, as long as he is prepared to give the CFTC additional information (probably a statement along the lines of “I promise I’m not manipulating the market”).

Years ago, I made the point to the CFTC that setting such a high limit in silver futures didn’t effectively limit anyone. It was akin to setting the speed limit in a school zone at 100 MPH. Their response was that there were smaller limits in the spot month, which ignored that the manipulation was occurring in the actively-traded months, not just the spot month. I made the point that the commercials were masquerading as hedgers when they were actually speculators. Their response was that since there were no position limits anyway, no one needed to masquerade. It was a pretty frustrating circumstance for me, having the CFTC argue with every single point I raised.

Now I think we have come full circle in many commodities, especially silver. Many people, including even those within the Commission itself, are finding it hard to argue with the obvious manipulative effects on the silver market. After all, an artificially depressed price must eventually result in shortage, something which is becoming more apparent in silver by the day. It is becoming obvious that the positions of the speculators, especially the largest concentrated shorts will destabalise the silver market, sooner or later.

Let me make this simple and offer a constructive suggestion for the regulators in the market I follow the most closely. Set position limits in silver futures at no more than 1500 net contracts, long or short, for all months. This is the same as the current spot month limit, and should be extended to include all months combined. The regulators must also crack down on commercials who pretend to be hedging, when it is obvious they are manipulating and controlling.

The potential developing shortage in silver threatens to blow the silver market sky high, exposing the manipulation to everyone, whether the regulators do anything or not. But if they don’t get out in front of this looming explosion, they will live the rest of their lives in shame.

The Emperor Has No Silver

Naked Emperors and Naked Shorts


Carl Loeb

Most every child is told a simple tale written by Hans Christian Andersen 170 years ago that illustrates certain enduring themes of how foolish powerful people can be when their pride is at stake. The story tells us of a vain Emperor who hires a couple of swindlers to make him what is to be a magnificent suit of clothes that the crooks tell the Emperor will be made of magical cloth that will be invisible to anyone who is stupid or unfit for their position. Naturally, the Emperor professes to be able to see the clothes (after all, he can’t be stupid or unfit), and so, of course, all of his ministers whose jobs depend of the Emperor’s favor are equally impressed with the magnificence of the new suit. After all, who wants to be the first minister to point out that the Emperor is an idiot?

We all know how the story ends. During a grand procession to show off his magic clothes and to general acclaim at how magnificent the Emperor looks, a small child points out the obvious. “But the Emperor has no clothes” notes the boy, and before long the obvious becomes, well, obvious and the entire crowd erupts in laughter at the silly Emperor. Interestingly, instead of fleeing the scene in embarrassed panic, and to salvage what might remain of his royal if buck naked dignity, the Emperor and his ministers continue with their grand procession, refusing to admit the obvious and maintaining the charade for as long as possible.

Hans Christian Andersen might well have had the Comex silver market and the CFTC Commissioners in mind when he wrote this morality tale. After all, little boys and little girls have been pointing out for years that steadily decreasing global stockpiles of silver set against growing demand for silver for both industrial and investment purposes cannot be squared with the massive and clearly naked short position of the largest 4 Commercial traders on the Comex. Little silver exists for retail delivery as this is written, and the various silver ETFs are busy vacuuming up any large quantities of silver as they become available.

The only place where the Emperor’s clothes existed was in his mind and the only place where silver now apparently exists in virtually unlimited quantities for sale to anyone seeking long contracts is in the minds of the Commissioners of the CFTC. The swindlers knew the clothes were fanciful, and the swindlers making up the 4 large traders on the Comex are counting on being able to continue to safely rely on the same mechanism that protected the Emperor’s rascally tailors – the desire of those in power to resist to the last possible moment what is obvious to even children – that they have been royally duped.

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